Buy ITC Ltd for the Target Rs. 400 by Motilal Oswal Financial Services Ltd
Unprecedent tax hike; valuation multiples to reset
* The government in its recent notification has increased taxes on cigarettes, effective from 1st Feb’26. New rates will increase the taxes on cigarettes by ~50% (assuming NCCD continues). ITC will need a price hike of atleast 25% at a portfolio level just to maintain the current net realization per cigarette stick. Moreover, earlier in GST 2.0, the government had revised GST rate on cigarette from 28% to 40% which will also implement from 1st Feb’26.
* Such a sharp tax increase is unprecedented and has surprised us given the backdrop of stable taxes over the last few years. Tax stability had impacted the illicit cigarette market, as its volume share contracted by ~150bp (Exhibit 3) over the last 4-5 years. ITC enjoyed this period, as its cigarette volume saw ~5% CAGR in the last five years, and the stock has run up over 50%.
* The tobacco lobby is opposing this tax increase, and we will see if there are any revisions in rates. However, if there is no change in taxes, we expect that it will significantly impact the legal cigarette market, and the price arbitrage between legal and illegal brands will be huge. It can shift volume from legal to illicit brands and could lead to downtrading within the legal brands.
* ITC has been very active on new product launches in cigarettes as taxes were stable; therefore, the product mix has been positive. Given the sharp price hike requirement, the mix will be weaker.
* Taxes were high during the 2012-2020 phase (Exhibit 4 - 7 times tax increase in 9 years), so the stock was range-bound during that period. However, ITC managed well and delivered positive EBIT growth. Since the tax increase is sharper this time, it will be a huge task for the company to protect its profitability. Its price hike strategy will be critical (full pass-on immediately or steady increase) to gauge the volume/EBIT sensitivity. We model 6% EBIT contraction in FY27 and will monitor the price hike process. Hence, our EPS cut is ~12% for FY27 and FY28.
* The stock has corrected ~10% on 1st Jan’26. Earnings pressure on cigarettes would take away the near-term catalysts (soft tobacco prices, recovery in FMCG and Paper) and comfort on valuation.
* We value cigarette business at 14x Dec’27E EV/EBITDA (similar multiple in earlier in high-tax cycle – Exhibit 5) vs. our earlier valuation multiple of 17x. We downgrade our rating from BUY to Neutral with a revised SoTP-based TP of INR400
Favorable phase of legal cigarette industry has passed
The cigarette industry has seen stable taxes for the last five years, leading to competitive pricing vs. illicit cigarettes. The illicit cigarette industry saw sharp gains during 2012-2021, with almost 1,000bp gain to ~28% volume mix. However, it has contracted during 2021-2025 by ~150bp to 26%. This supported the legal cigarette makers. ITC delivered healthy ~5% volume growth during this period. However, the current tax increase will again make illicit brands competitive, particularly with this high price arbitrage.
Cigarette operating and stock performance historically
The 2013-2021 period was a phase of high tax increases, which impacted the price competitiveness as compared to illicit brands. ITC managed the phase well and protected its market share and delivered positive EBIT growth during that period. However, the stock remained under pressure. With the current tax increase, it will be a difficult task for ITC to deliver positive EBIT growth given such a high price arbitrage. We model 6% EBIT contraction in FY27E.
Valuation: Cigarette may go back to historical multiples in high taxes In our SoTP calculation, we have seen low valuation multiples of cigarette business in high-tax periods. Such a huge tax increase will take some time for consumers to adapt and ITC to bring back its customers. We believe the valuation cycle will be weaker during this period. We now value cigarette business at 14x Dec’27E EV/EBITDA. Our new TP is INR400.
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